NEWS & RESOURCES

Authored by: Nathan Cacka, CPA, Financial Advisor

Understanding Like-Kind Exchanges: A Tool for Deferring Taxes on Property Investments

What is a Like-Kind Exchange and Why is it Done?

A like-kind exchange, often referred to as a 1031 exchange, is a tax strategy that allows property owners to swap one investment or business-use property for another while deferring capital gains taxes. Rather than selling a property outright and paying taxes on the proceeds, investors can reinvest their gains into a new property, postponing tax liability until a future sale.

This strategy is particularly useful when:

• A property owner has a large taxable gain on an asset they no longer wish to keep.
• They want to change the type of property they own—for example:
  • Transitioning from a family orchard to rental property.
  • Shifting from residential rental to commercial rental properties.
  • Converting vacant investment land into rental units.
  • Relocating their investment property to a different geographic area.
  • Diversifying from a single property to multiple units.
  • Moving from a hands-on investment to a passive investment, such as a Delaware Statutory Trust (DST).

The key benefit of a like-kind exchange is deferring taxes, not eliminating them. By continuously reinvesting through successive exchanges, investors can grow their portfolio while delaying tax obligations.

How is a Like-Kind Exchange Done?

Executing a 1031 exchange requires following strict IRS guidelines:

Step 1: Engage a Qualified Intermediary (QI)

A qualified intermediary facilitates the exchange, holding the proceeds from the sale and ensuring compliance with tax regulations.

Step 2: Sell Your Property

The investor sells their existing property. Instead of receiving the funds directly, the QI holds the proceeds to maintain tax-deferred status.

Step 3: Identify a Replacement Property Within 45 Days

Within 45 days of selling the original property, the investor must formally identify a replacement property. This can be done by submitting a written statement to the intermediary, specifying the new asset.

Step 4: Acquire the Replacement Property Within 180 Days

The investor has 180 days to complete the purchase of the replacement property. The new property must be of equal or greater value to qualify as a true exchange.

Step 5: Address Inequalities With “Boot”

If the value of the new property is less than the original property, something must be added to balance the transaction—this is called boot. Boot consists of:

• Cash received by the seller.
• Mortgage relief (if the new property has a lower loan balance than the original).
• Personal property that does not qualify as real estate.
• Non-qualified property that falls outside IRS guidelines.

Receiving boot triggers a taxable event, meaning the investor will owe taxes on the boot portion, even though the exchange remains partially tax-deferred.

Step 6: Report the Exchange on Form 8824

The investor must report the transaction to the IRS using Form 8824, detailing the properties exchanged and any boot received.

Important Considerations

Before pursuing a 1031 exchange, property owners should consider several key factors:

1. Liquidity Concerns

A like-kind exchange does not provide immediate cash liquidity. If an investor needs cash from their property sale, a 1031 exchange is not ideal.

2. Strict Deadlines

Failure to identify a property within 45 days or close the transaction within 180 days results in losing tax-deferred status, meaning the IRS treats the sale as a taxable event.

3. Conversion to Personal Use

If an investor converts the newly acquired property into personal use within two years, the IRS may disqualify the exchange, potentially leading to retroactive tax liability.

4. State-Level Regulations

State tax laws may differ from federal rules, potentially impacting tax deferral benefits. Investors should consult tax professionals to understand state-specific implications.

Final Thoughts

Like-kind exchanges can be a powerful tool for property investors looking to grow wealth while deferring taxes, but they require careful planning and adherence to IRS guidelines. By working with qualified intermediaries, staying within deadlines, and choosing suitable replacement properties, investors can leverage 1031 exchanges to strategically manage their real estate portfolios.

If you have questions about how capital gains impact your tax situation, contact us at cnccpa.com or call (509) 663-1661. We’re here to provide you with a complete financial team in your corner.